Managing counterparty exposures in a trading environment has become increasingly complex and time-consuming for traders managing large portfolios of concentrated risk. In many industries, trading limits are often imposed on corporations with respect to various counterparties. For example, in the energy industry, oil, gas, and other energy related corporations often have trading limits with respect to other corporations in the energy industry. The trading limits are generally instituted by internal management policies of each corporation, but alternatively may be set by an industry governing board or a government agency. The trading limits ensure that a corporation will not have credit exposure to a counterparty exceeding a predetermined dollar amount. Accordingly, given the trading limit, if a counterparty is driven out of business or experiences losses, the losses of the trading partners are limited by their own internal trading limits.
The types of transactions between counterparties may involve derivative transactions such as futures, forwards, swaps, or the like, for various commodities like oil, gas, power, and others. For example, in the energy commodities market (oil, gas, power), parties will regularly enter into forwards whereby an amount of oil will be sold at a certain price for a certain amount of time. For example, an oil company may enter into oil forwards at a fixed price for the next five years with a counterparty. However, the oil company may have an exposure limit with respect to the counterparty so that if the counterparty dissolves, goes bankrupt, or otherwise becomes unavailable to fulfill it's obligations, the oil company's losses will be cemented by the exposure limit.
Often, corporations have a desire for highly correlated non-diversified exposures. In the example provided above, even though the oil company may have other trading partners, it may desire to exceed its trading limit with respect to the above-mentioned counterparty. For example, the oil company may have a trading limit of $10 million with respect to the counterparty. A situation may occur in which the oil company needs to take a position with respect to the counterparty which requires the oil company to exceed this $10 million credit limit. Depending on the internal policies or industry rules, the oil company will either be prohibited from taking this action or will be severely penalized by regulators for taking this action.
Existing solutions to this problem include requiring the traders to seek approval from internal management and/or to obtain insurance against the over-exposed position. In order to seek approval from internal management, the corporate investors may be required to consult a Board of Directors or predetermined officer to obtain permission to engage in a transaction that exceeds the normal restrictions. Management may require the traders to purchase insurance or a credit default swap (CDS). A CDS may refer to a bilateral contract between a protection buyer and a protection seller. The CDS will reference the creditworthiness of a third party and will relate to the specified debt obligations of the third party which fulfill certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction. The relevant credit events specified in a transaction will usually be selected from amongst the following: the bankruptcy of the reference entity; its failure to pay in relation to a covered obligation; it defaulting on an obligation or that obligation being accelerated; it agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation. Both insurance and CDS solutions can be prohibitively expensive.
Thus, taking large exposures to energy industry counterparties can be challenging due to internal counterparty credit limitations specific to counterparties, the desire for highly correlated non-diversified exposures, and lack of availability of low-cost and term specific hedges, which are investments that are designed to reduce or cancel out the risk in another investment. Lack of efficient solutions can lead to lost trades and profits for clients.
Accordingly, a solution is needed that facilitates trading between organizations within an industry while simultaneously avoiding the expenditures required for insuring against overexposure as well as the procedures required for seeking management approval for an over-exposed position.